How do collateralized loans work?

Collateralized loans are a type of secured loan where the borrower pledges an asset as collateral to secure the loan. Here's how they work:

1. Pledging Collateral: The borrower offers an asset (like real estate, stocks, or other valuable property) as security for the loan. This collateral helps reassure the lender that they can recover their money if the borrower defaults on the loan 1 2.

2. Loan Amount and Collateral Value: Typically, the loan amount depends on the value of the collateral. For instance, in margin borrowing, borrowers can use their existing stocks as collateral to receive a loan from their brokerage. The broker holds these stocks and can sell them if the borrower fails to repay the loan 3.

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     1

     Understanding CLOs

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     2

     Managing Crypto Loans

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     3

     Margin Borrowing Explained

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     4

     Permissionless Lending Risks

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3. Over-Collateralization: Often, the value of the collateral must exceed the loan amount, providing a buffer for the lender. For example, in crypto lending, borrowers might need to put down more collateral than the amount they wish to borrow, such as placing $1.50 worth of collateral to receive a $1 loan. This ensures the loan's security even if the collateral's value drops 4.

4. Loan Terms: The terms of the loan, including interest rates and repayment schedules, are defined in a loan agreement. This agreement also outlines what happens if the borrower cannot repay, such as the lender's right to seize and sell the collateral 3.

5. Risks and Margin Calls: If the value of the collateral drops below a specific threshold, the borrower may face a margin call, requiring them to either provide additional collateral or repay part of the loan immediately. Failure to do so can lead to the lender selling the collateral to recover the loan amount 2 3.

Key Points:

• Secured by Assets: The loan is secured by the borrower's asset.
• Over-Collateralization: Collateral value often exceeds the loan amount.
• Managed Risk: Lenders can protect themselves against non-repayment by using the collateral.
• Margin Calls: Protect lenders by requiring additional collateral if the asset's value decreases.

These features make collateralized loans a popular choice for both personal and institutional borrowers, as they can provide better terms and lower interest rates compared to unsecured loans.